Electricity is by its nature difficult to store and has to be available on demand. Consequently, unlike for other products, it is not possible, under normal operating conditions, to keep it in stock, ration it or have customers queue for it. Demand and supply vary continuously. There is therefore a physical requirement for a controlling agency, the system operator[?], to coordinate the dispatch of generating units to meet the expected demand of the system across the transmission grid. If there is a mismatch between supply and demand the generators speed up or slow down causing the system frequency (either 50 or 60 Hertz) to increase or decrease. If the frequency falls outside a predetermined range the system operator[?] will act to remove either generation or load.

In addition, the laws of physics determine how electricity flows through an electricity network. Hence the extent of electricity lost in transmission and the level of congestion on any particular branch of the network will influence the economic dispatch[?] of the generation units.

For an economically efficient electricity wholesale market to flourish it is essential that a number of criteria are met. Professor William Hogan (http://ksghome.harvard.edu/~.whogan.cbg.Ksg/) of Harvard University has identified these. Central to his criteria is a coordinated spot market that has "bid-based, security-constrained, economic dispatch with nodal prices". Other academics such as Professors Pablo Spiller (http://faculty.haas.berkeley.edu/spiller/olderindex.htm) and Shmuel Orem of the University of California, Berkeley have developed other criteria. Professor Hogan's model has largely been adopted in New Zealand and supported by the US Federal Energy Regulatory Commission in its proposed Standard Market Design.

The price of electricity at each node on the network is an aggregation of the marginal[?] electricity generator's offer price and the marginal cost[?] of losses and congestion on the network. This is known as "locational marginal pricing" (LMP) or "nodal pricing". Where congestion exists on a transmission network, there is a need for load to be shed or more expensive generation to be dispatched on the downstream side of the constraint. Prices on either side of the constraint separate giving rise to congestion pricing and constraint rentals[?].

A constraint can be caused when a particular branch of a network reaches its thermal limit or when a potential overload will occur due to a contingent event on another part of the network. The latter is referred to as a security constraint. In essence, transmission systems are operated to allow for continuity of supply even if a contingent event, like the loss of a line, generator or transformer, were to occur. This is known as a security constrained system.

The marginal generator is determined by matching offers from generators to bids from retailers at each node to develop a classic supply and demand equilibrium price. This process is carried out for each 5-minute, half-hour or hour (depending on the market) interval at each input and exit node on the transmission grid. The prices take into account the losses and constraints in the system and generators are dispatched by the system operator, not only in ascending order of offers (or descending order of bids), but in accordance with the required security of the system. This results in a spot market with "bid-based, security-constrained, economic dispatch with nodal prices".

A consequence of the complexity of a wholesale electricity market is the price volatility at times of peak demand and supply shortages. This is manifest by price "spikes" which are hard to predict and price "steps" when the underlying fuel or plant position changes for long periods . Electricity retailers, who buy from the wholesale market, are exposed the these price effects and to protect themselves from volatility, they will enter into "hedge contracts" with generators. These contracts are generally contracts for differences[?] where the parties agree a "strike" price for defined time periods. If the actual wholesale price in any time period is higher than the "strike" price, the generator will refund the difference berween the "strike" price and the actual price for that period. Similarly a retailer will refund the difference to the generator when the actual price is less than the "strike price". The actual price is sometimes referred to as the "spot" or "pool" price, depending on the market.

A retail electricity market exists when end-use customers can chose their supplier from competing electricity retailers.

Generally, electricity retail reform follows from electricity wholesale reform. However, it is possible to have a single electricity generation company and still have retail competition. If a wholesale price can be established at a node on the transmission grid and the electricity quantities at that node can be reconciled, competition for retail customers within the distribution system beyond the node is possible.

Although market structures vary, there are some common functions that an electricity retailer has to be able to perform, or enter into a contract for, in order to compete effectively. Failure or incompetence in the execution of one or more of the following has led to some dramatic financial disasters:

The two main areas of weakness have been risk management and billing. In the USA in 2001, California's flawed regulation of retail competition left incumbent retailers subject to high spot prices but without the ability to hedge against these (see Manifesto on The Californian Electricity Crisis (http://faculty.haas.berkeley.edu/spiller/eleabs.htm#Manifesto%20on%20the%20California%20Electricity%20Crisis)). In the UK a retailer, Independent Energy, with a large customer base went bust when it could not collect the money due from customers.

In the main, experience in the introduction of retail competition has been mixed. The UK, Australia and New Zealand have achieved some success.
Among the countries in the world that have developed successful wholesale electricity markets are:

A paper by Prof William Hogan of Harvard University setting out the principles for efficient wholesale electricity markets, with examples of efficient markets as well as an analysis of why the California market failed A Market Framework (http://ksghome.harvard.edu/~.whogan.cbg.Ksg/rut052501_pres_hogan.pdf)